The UK and Scottish governments are engaged in a set of parallel and overlapping games in the economic and political arenas. CEPR Policy Insight 73 presents research that analyses how decisions about whether to cooperate over financial regulation, fiscal rules, and the choice of currency and monetary policy, will all have far reaching implications for a newly independent Scotland and the rest of the UK.

The UK and Scottish governments are engaged in a set of parallel and overlapping games in the economic and political arenas. This column presents research that analyses how decisions about whether to cooperate over financial regulation, fiscal rules, and the choice of currency and monetary policy, will all have far reaching implications for a newly independent Scotland and the rest of the UK.

Much ink has been spilled over Scotland’s currency options in the event of independence. This column argues that a breakup of the sterling area would be truly unprecedented. The sterling union is unique because it services a unitary state with a highly integrated and complex financial sector, an indivisible payments system, and an overlapping legal system. Politics aside, neither a unilateral nor a mutual break-up would be credible, leaving a negotiated currency union as the only option. However, as the Eurozone crisis demonstrates, a badly designed currency union could be exceptionally costly.

Is the trinity impossible? This column traces the evolution of the three aspects of the trilemma – exchange rate stability, monetary independence, and financial integration – across countries over the last four decades. A rise in one trilemma variable does result in a drop of a linear weighted sum of the other two.

Since World War II, economies have exited currency unions at an average rate of one per year. Yet the evidence confounds established theory: economists are unable to predict which economies are likely to leave currency unions.

US and EU pressure on China to revalue the renminbi create the mistaken impression that there is an unavoidable conflict of interests. A switch by China to a more flexible exchange rate regime, accompanied by a shift to a new nominal anchor, would serve China’s domestic interests and simultaneously defuse protectionist sentiments abroad. A politically savvy recasting of this issue as one of Chinese monetary-policy independence could help solve many problems.